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In the financial world, the interest rate is what an individual or institution pays for loaned money. This can be an individual paying a bank for a loan it issued, or a bank paying an individual who has money in a bank account. Commercial bank interest rates for savings accounts and loans is affected by factors such as borrower demand in the loan market, inflation rates, and the credit worthiness of individual borrowers.
Banks issue loans with the money that individuals and institutions have deposited in their different savings, checking, or money market accounts. Financial institutions give depositors an incentive to leave their money in these accounts, allowing the institution to use it for loans, by paying interest on the money in these accounts. Commercial bank interest rates for these accounts are higher overall when the bank is in greater need of money to lend. Banks will also pay higher interest rates for accounts from which customers are less likely to withdraw their money. This is why certificates of deposit, from which depositors cannot withdraw money before a certain date without paying a penalty, pay higher interest rates than regular savings accounts.
Loans are a bank's main source of revenue. They are the product that the bank is offering to customers. When there are a large number of borrowers applying for loans, banks can charge higher interest rates. When the number of borrowers applying for loans is reduced, banks usually charge lower interest rates to attract more customers.
Inflation is a major concern for commercial bank interest rates within these higher or lower ranges. The rate of inflation determines how much purchasing power, and real value, each unit of currency loses every year. If the annual interest rate is 5%, then the same amount of money this year is 5% less valuable than it was last year. If the rate of inflation exceeds the interest rate that a bank is charging on a loan, then the bank could end up losing money in the transaction. For this reason, banks estimate what the rate of inflation will be during the time in which a borrower will be repaying a loan.
After taking into consideration the market's demand for loans and projected inflation, commercial bank interest rates are based on an individual borrower's credit worthiness. An individual with a good credit history is more likely to repay the loan than an individual with a poor one. If a bank is going to loan money to an individual who is less likely to repay his or her loan, it will charge a higher interest rate than it would for someone who is more likely to repay the loan.
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